OCERS investments

Orange County's public pension system poured money into hedge funds, private equity and other so-called alternative investments during the past six years, but the returns have proven mediocre despite costing millions in fees.

This year alone, the fund is expecting to pay $54.5 million to alternative-investment managers, according to a budget briefing document obtained by the Orange County Register.

But in financial reports through the first half of the year, the pension system disclosed none of those fees. Officials said they are following standard government reporting practices.

Indeed, the Orange County Employees Retirement System is not alone.

As pension funds nationwide struggle to make up large unfunded liabilities, public officials have shifted billions of dollars to risky investments like hedge funds instead of traditional stocks and bonds. Fund leaders say it’s a way to diversify their portfolios, and they argue for patience with new investments.

But experts say the results, in most cases, have been lackluster earnings for public pension funds and a boon for Wall Street money managers.

“This is a huge feeding frenzy,” said Edward Siedle, whose Florida forensic firm Benchmark Financial Services investigates pension funds. “Never have the fees been as expensive and egregious and opaque … and you can’t justify the performance.”

Orange County’s two main alternative classes – hedge funds, and a mix of commodities, energy and other investments – earned 3.4 percent and 7.8 percent, respectively in 2012, while the S&P 500 earned 13.4 percent. The OCERS real estate fund did better than other alternatives, earning 12.6 percent.

The overall performance of OCERS’ $10.7 billion fundhas lagged behind other public pension systems during the three years ending December 2012. Among 88 of the largest pension systems in the country, OCERS ranked 86, according to a Register analysis of data provided by Pensions & Investments, an industry trade publication.

OCERS reported total returns of 8.1 percent, while other funds, such as the Sacramento, San Bernardino and San Diego county pension systems, notched 9.9 percent and above. Fairfax County, Virginia topped the rankings with earnings of 17 percent.

Siedle, a former Securities and Exchange Commission attorney, estimates that OCERS missed out on more than $125 million of profit during 2012.

Some of those foregone earnings went to the investment managers’ pockets, as hedge funds and private equity firms often take a cut from the returns.

Reducing fees is now a focus for new OCERS Chief Investment Officer Girard Miller. On Wednesday, he expects to unveil a plan to pool alternative investments with other California pension systems and then bargain for lower fees.

“We take it very seriously,” Miller said about alternative-investment fees.

Alternative-investment firms command enormous fees compared with those of traditional managers. Typical of the OCERS hedge funds, Bridgewater Associates charges 1.5 percent of the assets it manages, plus 20 percent of profits if it surpasses a certain benchmark.

That is more than 180 times the rate charged by the OCERS basic U.S. stock market fund, a Blackrock index, which charges 0.008 percent of the assets alone.

Just a portion of the total fund investment fees are reported on the OCERS comprehensive annual financial reports. In 2012, for instance, the fees were about $51 million, according to the budget documents, but the CAFR said $32 million.

This happens, in part, because some managers invest in smaller funds, and those smaller funds take a second layer of fees that is hidden in the lower return rate, OCERS officials say.

Pension systems follow Governmental Accounting Standards Board practices, which require all fees to be broken out, unless they are “not readily separable.” A GASB representative said it is up to an agency’s accountant to decide whether such fees should be disclosed, although the fundamental guidance is to show the fees separately.

But opacity is common in the public pension industry, says Siedle, who uncovered tens of millions in obscured fees at the Rhode Island pension fund.

“They have strategically decided to not disclose these fees,” Siedle said.

OCERS Chief Executive Officer Steve Delaney said officials knew that the fees were high but, until Miller was hired in 2012, had not taken the time to quantify the full costs.

Miller, formerly a top executive at Janus Capital Group and Fidelity Investments, said the fees are sometimes justified: “I’m happy to pay for performance when I get it.”

But he acknowledges “there’s a fair criticism” that hedge funds haven’t performed very well recently.

GROWING PIECE OF THE PIE

The notion that high-cost and high-effort investment strategies often flop is not a new one. In a friendly wager, Warren Buffett bet hedge fund manager Protégé Partners $1 million in 2008 that a stock market index, like the S&P 500, would get better returns over 10 years than the hedge fund.

By the beginning of 2013, the stock index had earned 8.7 percent, while Protégé’s hedge funds had earned 0.1 percent.

But members of the OCERS board have shifted more and more of their fund into alternatives. As of September, OCERS had $3.2 billion of its $10.7 billion portfolio in alternatives, which have ballooned from 6 percent of the total fund in 2006 to 30 percent today.

That does not include real estate investments, which most industry observers also consider to be alternatives.

Including real estate, OCERS has 39 percent of its portfolio in alternatives. The national average among state pension funds, by comparison, is 24 percent, according to investment adviser Cliffwater.

“I don’t know how it morphed to that size,” said county Supervisor John Moorlach, who served on the OCERS board until 2006. “What was the logic?”

Moorlach, who identified problems with the Orange County Investment Pool before its collapse triggered the county’s 1994 bankruptcy, said he grows nervous, in general, if such an asset class is more than one-seventh of a portfolio.

Contacted individually to discuss the fund’s performance, eight of the 10 OCERS board members either did not respond or declined a request for an interview. Some cited a board policy that directs media inquiries to a spokesperson. The policy also says board members are supposed to “respect the decisions and policies of the board … even if they may have opposed them.”

Member Frank Eley, who represents general county employees on the board, was one of the few who would comment. Eley said he expects the alternatives to perform better over time.

“I’m not concerned, because I think you have to build a system that lasts for all times,” Eley said. “The only thing that saved us in 2008 was having the most diversified portfolio.”

Miller said the recent OCERS earnings doldrums can be attributed to the diverse asset mix. OCERS isn’t as tied to the stock market as some other funds, so it didn’t fully reap the market gains when public companies rebounded. Also, some of the alternative funds may not hit their full stride for another three to four years, Miller said.

Over the five-year period, when its alternative investments performed better, OCERS finished sixth out of the 88 largest systems.

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